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The ETF 92-8 Rule

I’m sure most of you are familiar with the “80-20 rule.” It’s more formally known as the Pareto Principle and is sometimes referred to as the “law of the vital few.” In summary, the principle says that roughly 80% of the observable outcome is the result of 20% of the inputs. This is the source of the business rule-of-thumb that 80% of sales typically come from 20% of the customers.

When it comes to ETF trading, the world is skewed even more. I have written extensively about the large number of ETFs and ETNs that see little trading action. In fact, it is the basis for my ETF Deathwatch, which currently has 142 names. I have also noted that many ETFs often have zero-volume days.

Likewise, the other end of the trading spectrum is dominated by a small handful of elite ETFs that I call the ETF Billion Dollar Club. These funds grab the lion’s share of the action. I look at Average Daily Value Traded (ADVT), which is volume multiplied by price, to measure trading activity because low-priced shares have the potential to drastically distort raw share volume numbers.

I have often noticed that ETF trading is more concentrated than the 80-20 rule suggests. However, until this morning, I had never calculated it. There are many ways to do so. For example, I could assume that either the 80 or 20 is fixed and solve for 80-x or x-20. However, I believe the “spirit and beauty” of the Pareto Principle lies in the fact that the two numbers add up to 100.

With that as my goal, I set out to determine what % of the ETF and ETN population are truly the vital few. My most recent monthly data shows that 70 ETFs and ETNs (~8%) accounted for 92% of ETF and ETN ADVT.

The results will surely fluctuate from month to month, of course. Yet for ETFs, the 80-20 rule looks more like a 92-8 rule.

The catchy part of the “92-8″ rule is that the two numbers add to 100%. There is no reason that 92% of the ETF-ETN’s could not account for 92% of the volume. It’s just snappier if the two add to 100%.

What is really being conveyed here is a single high-impact sample of the distribution of ADVT among the ETF-ETN’s. If we lined up the ETF-ETN’s on the x-axis, in descending order of ADVT, and plotted the cumulative ADVT on the y-axis, the “92-8″ rule is just a point on the curve. In fact, if we normalize both axes to range from 0 to 100%, then there is just one such point on every AVT-ETFN curve, and it is the point at which x+y=100.

This is all pretty obvious but I thought it worth mentioning anyway. Since the point is unique, no matter what we are dealing with, we can legitimately ask for the “crossing point” in lots of interesting situations. What is the crossing point of profits among US companies?

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